Wedbush Morgan: Game Industry Transition 'Only Just Begun'

Author: by Brandon Sheffield, Simon Carless

Wedbush Morgan Securities analyst Michael Pachter has analyzed the recently released March NPD results in his latest note to investors, adding a more detailed report on the state of the video game industry, and its viability to investors as the console transition continues, suggesting that the difficult hardware and software transition period has "only just begun". "It appears that 2006 is following a similar pattern to 2000," Pachter commented, referring to the last advent of a hardware generation. "Consumers have slowed purchases of current generation console software while waiting for the opportunity to purchase an incredible next generation console, the Xbox 360, and its associated software," he said, largely bullish on the Microsoft console. The hardware shortage issue has not escaped his grasp, however, as he states that: "While Microsoft indeed delivered an incredible machine, few consumers have thus far been able to actually purchase one. Through March, NPD data shows that Xbox 360 hardware sales in the U.S. were 1.2 million units, and consumers appear poised to purchase compelling software like Ghost Recon and Elder Scrolls upon release." Again, though, Pachter's future projections for the Xbox 360 err on the side of the positive: "We are optimistic that Microsoft will remedy the supply/demand imbalance in the U.S. in April, as it appears that recent manufacturing capacity is beginning to show up in the retail channel. As such, we think that Xbox 360 software sales could be even higher in April, and think that overall sales for the month may inch into positive territory." He then went on to lay out his predictions for the general outlook of the next few months, as related to Microsoft's new machine. "Notwithstanding the phenomenal sell-through of Xbox 360 software in March (a tie ratio of over 8) and our expectation that the tie ratio for April will again be strong, we think that it is possible (even likely) that software attach rates during the following several months will be around 3 units per Xbox 360 hardware unit sold, particularly as the release dates for many key sequels appear on the horizon. This means that Xbox 360 software sales will only contribute $50 – 60 million per month beginning in May, far lower than the current generation software sales trend of a -30% rate, down around $100 million per month for each of the next several months." As for the current generation, Pachter notes that "The U.S. hardware installed base currently stands at 98 million current generation consoles (including handhelds) as of the end of March 2006 (up from 95 million at year end 2005). And though we expect modest growth in April, we expect declines to continue through June. The top April releases are Eidos’ Tomb Raider: Legend (360, PS2, Xbox, PC, PSP) and Take-Two’s Major League Baseball 2K6 (PS2, Xbox, 360, PSP, GC)" As an overarching look, Pachter expects rather markedly lower revenue in the continuing year. "We expect U.S. video game software dollar sales to decline 4% in 2006. We think that the transition has only just begun, and believe that the worst effects of the transition lie ahead. Although we expect a brief respite from double-digit sales declines in April, when Microsoft is likely to double the supply of Xbox 360 hardware units, we expect a return to software sales declines over the following several months." As far as those looking to throw their hat into the game arena, the analyst offers this advice: "Should this [decline] occur, many investors may begin to question the health of video game publishers, and may begin to question whether these stocks make sound investments. This uncertainty could be exacerbated should Sony or Nintendo delay the launch of their respective next generation consoles, expected in November and October, respectively. We do not believe that investors have appropriately considered the risk of the console transition, with share price stubbornness indicating to us that most investors think that the transition is behind us." Finally, Pachter cautions current game company investors, stating that "In contrast, we think that the transition has only just begun, and believe that the worst effects of the transition lie ahead. We believe that the publishers are, indeed, very sound investment vehicles, but believe that the risks of the transition are misunderstood."